Blog

Snatching Victory from the Jaws of Defeat

You messed up, and time has gone by. You wanted to claim the foreign earned income exclusion on a tax return, but the filing deadline for that tax return was more than a year ago.

You are very late. Maybe you filed a tax return and missed making the claim for the foreign earned income exclusion. Maybe you did not even file a tax return at all.

Let’s talk about how you can claim the foreign earned income exclusion. To do this we will talk about the rules, and a recent Tax Court case that demonstrates the rules in action. The Court handed an unpleasant result to a taxpayer.

Everything I write here can be boiled down to a simple statement:

It’s a race.

If you get file Form 2555 before the IRS figures out you didn’t, you win. You get the tax break.

If the IRS figures out that you didn’t file Form 2555 before you file Form 2555, you lose.

Get moving and file your tax returns.

As a crusty old boss of mine once said to my 18-year old self, “Pull the finger out.” (Typically blunt Kiwi, he was. I was a slug working at Coronet Peak running a chairlift and doing odd jobs around the resort. He thought that perhaps I could put some speed into my work. I just thought the figure of speech was hilarious; my work rate did not speed up appreciably.)

The Foreign Earned Income Exclusion

The foreign earned income exclusion is one of the few fabulosities of the U.S. tax system. You want it.

Briefly, Americans living abroad can pay zero income tax on earned income (money you make by working, not money you make from investments).

There is a limit to how much much you can earn without paying income tax: $102,100 on your 2017 income tax return.1

There are some absurdly technical conditions you must satisfy in order to claim the foreign earned income exclusion.2 Let’s not dissect that frog today. We will just talk about the paperwork: what you need to file, and when.

What to File

If you want the foreign earned income exclusion, you have to do the paperwork. The law says you must make an “affirmative election”.3

The ability to eliminate income tax on earned is an choice, requiring action. It is not a God-given right. If you don’t make the election, you don’t get the tax break.

The way you make the election is by filing Form 2555 attached to your income tax return.4

When to File

But when do you file Form 2555? Congress gave the IRS full power to decide the “when” question. And there are four answers to that question.

On Time

The first rule says that Form 2555 must be filed with a “timely” income tax return.5 That means your normal filing date, plus any extensions that you received.

If you do this, you have made a valid election to exclude foreign earned income from being taxed. The IRS must accept your election.

More Than a Year Late

The other three answers deal with situations where you missed the normal filing deadline (with or without extensions). These rules specify when you can be late in filing Form 2555, and the IRS must accept the foreign earned income exclusion election as valid.

Let’s focus on the rule that applies if you are more than a year past the filing deadline.

Example

You never filed a 2014 income tax return. You meet all of the requirements for the foreign earned income, but you never made the election on Form 2555, because (duh) you haven’t filed an income tax return at all.

The filing deadline for the 2014 income tax return was 15 June 2015. That is more than one year ago.

Here is the rule if you are more than a year late:

You owe zero income tax when you calculate your tax liability with the foreign earned income exclusion applied? The IRS must accept your Form 2555 as a valid election. You win.6 Even if you are under audit, the foreign earned income exclusion will work for you.

You owe any income tax at all after you apply the foreign earned income exclusion? It’s a race. You must file Form 2555 before the IRS discovers you.7

Example: no income tax due

A typical digital nomad might have only self-employment income, reported on Schedule D. If the math works out correctly, the foreign earned income exclusion might eliminate all of the income tax liability.

The digital nomad will, however, owe self-employment tax on that Schedule C income.

No worries. If our digital nomad files a late Form 2555 to claim the foreign earned income exclusion, it will work, even in the middle of a hostile audit. The only requirement is that no income tax be due. The fact that a hefty self-employment tax bill awaits our digital nomad is of no consequence.

Example: income tax due

Our typical digital nomad again. This time, our friend has $50 of interest income in addition to the Schedule C income derived from independent contractor services rendered.

The late Form 2555 is filed, and completely eliminates income tax on the self-employment income.

However, there is income tax due on the $50 of interest income.

Now, after giving effect to the foreign earned income exclusion, an income tax liability still exists because of the $50 of interest income.

Now it is a race. If the digital nomad has already been found by the IRS, it is too late. The IRS can (and will) reject the foreign earned income exclusion.

Redfield v. Commissioner

An April 26, 2017 Tax Court decision — Redfield v. Commissioner — covered exactly this problem. There, the taxpayer filed his 2010 income tax return with Form 2555 attached in 2014, but unfortunately about four months after the IRS had filed a substituted return for him.

The opinion says, essentially, “rules is rules” and despite some sympathetic facts the Judge denied the foreign earned income exclusion.